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Chilean-type capital controls: A building block of the new international financial architecture?

Listed author(s):
  • Buch, Claudia M.

Taxes on short-term capital flows such as introduced in Chile and Slovenia during the 1990s in the form of unremunerated reserve requirements (URRs) on financial credits are under discussion as a remedy against adverse effects of volatile international capital flows. From a theoretical point of view, URRs find support from the fact that financial markets react faster to exogenous shocks than goods markets. A high volatility of capital flows, in turn, may reduce investment and exports, and thus negatively affect overall growth. A tax designed to reduce inflows of (short-term) capital and to enhance the autonomy of domestic monetary policy may therefore raise welfare. Yet, the effectiveness of URRs is limited because capital controls can at best delay but not prevent speculative attacks on misaligned currencies. Moreover, a temporary introduction of capital controls, as is often proposed in the case of an acute financial crisis, may have the adverse effect of increasing rather than lowering financial market volatility. The empirical evidence from Chile and Slovenia shows that URRs are no panacea and that the gain in monetary autonomy has been limited. While the composition of inflows has changed towards flows exempted from the URR, the overall inflow of capital has increased, and interest rate effects have been short-lived. There is no evidence that the volatility of capital flows has declined. Exchange rate volatility seems to have come down, albeit possibly as a result of exchange market intervention. Capital controls are often proposed as a tool to promote the stability of the financial sector. More specifically, it is often argued that external financial liberalization should proceed only after sufficient progress has been made in reforming the domestic banking system. Yet, the administrative capacity to enforce capital controls is typically weak precisely in those countries which have poorly supervised and thus potentially unstable banking systems. Also, foreign competition can enhance the efficiency of the domestic financial sector. Thus, progressing simultaneously on internal and external financial liberalization seems the preferable option. At the time of opening up for foreign capital, minimum prudential standards should be in place. Also, public deposit guarantees should have been abolished in order to limit the risk of overborrowing and moral hazard. The imposition of capital controls may even send negative signals to investors and thus affect investment negatively. Exposure to external shocks should rather be reduced by pursuing structural reforms, by following sound macroeconomic policies, by disseminating clear and transparent information, and by using market mechanisms to alter the structure of foreign debt. This also allows for a more efficient use of scarce administrative resources. In this context, international institutions have an important role to play in designing and enforcing an institutional framework in which such mechanisms can be implemented.

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Paper provided by Kiel Institute for the World Economy (IfW) in its series Kiel Discussion Papers with number 350.

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Date of creation: 1999
Handle: RePEc:zbw:ifwkdp:350
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  1. Eichengreen, Barry & Tobin, James & Wyplosz, Charles, 1995. "Two Cases for Sand in the Wheels of International Finance," Economic Journal, Royal Economic Society, vol. 105(428), pages 162-172, January.
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  8. Buch, Claudia M. & Heinrich, Ralph P. & Pierdzioch, Christian, 1998. "Taxing short-term capital flows - An option for transition economies?," Kiel Discussion Papers 321, Kiel Institute for the World Economy (IfW).
  9. Joshua Aizenman, 2003. "Capital Mobility In A Second--Best World: Moral Hazard With Costly Financial Intermediation," Review of International Economics, Wiley Blackwell, vol. 11(1), pages 1-17, February.
  10. Robert E. Lipsey & Robert C. Feenstra & Carl H. Hahn & George N. Hatsopoulos, 1999. "The Role of Foreign Direct Investment in International Capital Flows," NBER Chapters,in: International Capital Flows, pages 307-362 National Bureau of Economic Research, Inc.
  11. Sebastian Edwards, 2000. "Capital Flows, Real Exchange Rates, and Capital Controls: Some Latin American Experiences," NBER Chapters,in: Capital Flows and the Emerging Economies: Theory, Evidence, and Controversies, pages 197-246 National Bureau of Economic Research, Inc.
  12. Salvador Valdés-Prieto & Marcelo Soto, 1998. "The Effectiveness of Capital Controls: Theory and Evidence from Chile," Empirica, Springer;Austrian Institute for Economic Research;Austrian Economic Association, vol. 25(2), pages 133-164, January.
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